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CHAPTER 1
CONTENTS
Introduction
Nature and Scope of Financial Management
Role of finance function
Finance decisions for the firm• Investment decisions• Financing decisions• Dividend decisions• Working capital decisions
Integrated view of finance decision-making
Financial decision making frameworkFINANCIAL MANAGEMENT – AN OVERVIEW
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CONTENTS
Key issues in financial decision making
Objective function in finance
Agency cost and Corporate Governance
Financial Management and Accounting
Financial objectives and organisational strategy
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INTRODUCTION
Basic issues in finance are essentially the same for diverse businesses.
The key issues in finance are:• Where to raise financial resources from?
• Wherein to invest the resources?
• How best to manage the production-distribution function?
• How much of profit to distribute and how much to retain?
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NATURE AND SCOPE OF FINANCIAL MANAGEMENT
Concerned with the management of financial resources.
Performs facilitation, reconciliation, and control functions.
Covers all decisions having monetary implications.
The finance manager is on the top and not on the tap.’
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ROLE OF FINANCE FUNCTION
Finance is central to all business activities.
Finance function reconciles the conflicting interests of:
• varied stakeholders and
• different functional units.
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FINANCE DECISIONS FOR
THE FIRM
Financial decision-making involves procurement of funds and their optimal utilization through:
• Investment
• Financing
• Dividend and
• Working capital decisions.
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INVESTMENT DECISIONS
Aim at selecting the most productive avenues that maximize the ROI.
Examples include:
• Expansion
• Modernization and replacement
• R&D expenditure.
Also referred to as capital budgeting decisions.
Are critical for long-term survival and growth.
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INVESTMENT DECISIONS
Are taken in the light of their probable impact on the wealth of shareholders.
Involve huge capital outlay.
Have long-term implications.
Are usually irreversible.
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FINANCING DECISIONS
Vaguely referred to as capital structure decisions.
Mainly concerned with:• Identifying the suitable sources of funds
• Tapping of these sources.
Determine the financial risk.
Thrust is to bring down the cost of financing.
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FINANCING DECISIONS
The main issues involved are:• Where from to procure the requisite funds?
• What should be the optimal mix of various sources of capital?
• How much should be the proportion of short-term and long-term funds?
• How do the expectations of providers of each source of capital change with alteration in the capital mix?
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FINANCING DECISIONS
Are taken in the light of their likely impact on the wealth of the stockholders.
A right blend of debt–equity affects the risk return profile of the business.
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DIVIDEND DECISIONS
Are mainly concerned with deciding the mix of profits to be distributed as dividends and those to be ploughed back for future financing needs of business.
Depend on trade off between future financing needs of the firm and current consumption requirements of the shareholders.
Generally, firms in sectors with a high-growth rate follow a policy of high retention and low payout.
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DIVIDEND DECISIONS
Determining the payout ratio and the method of dividend payment are the two concerns of dividend policy.
The payout ratio is decided in the light of its probable impact on shareholders’ wealth
Normally, firms follow a policy of stable dividends
Dividend policy is considered as a residue of investment and financing policy.
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WORKING CAPITAL DECISIONS
Are concerned with the management of current assets.
The two key decision points in working capital management are:
• Level of investment in current assets
• Financing of current assets.
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INTEGRATED VIEW OF FINANCE DECISION-
MAKING
The four key decision areas in finance are the part of an integrated decision making framework in finance.
They are directly linked and reinforce each other.
All the decisions have a common objective function-shareholders’ wealth maximization.
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FINANCIAL DECISION MAKING FRAMEWORK
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KEY ISSUES IN FINANCIAL DECISION-MAKING
Investment Decision
• What business to be in?• What growth rate is appropriate?• What assets to acquire?
Financing Decision
• What mix of debt and equity to be used?• Can we change value of the firm by changing the capital
mix?• Is there an optimal debt–equity mix?
Dividend Decision
• How much of the profit should be distributed as dividends and how much should be ploughed back
• Can we change value of the firm by changing the amount of dividend?
• What should be the mode of dividend payment
Working Capital Decision
• What level of inventory is ideal?• What level of credit should be given to the customers? • What level of cash should be maintained?• How can the blockage of funds in the current assets be
minimized without compromising with profits?
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OBJECTIVE FUNCTION IN FINANCE
The goal of wealth maximization is the widely accepted goal of the business.
It reconciles the varied, often conflicting, interest of the stakeholders.
It is free from the limitations that other objectives are faced with.
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AGENCY COSTS AND CORPORATE
GOVERNANCE
The stakeholders in business are multiple, their stakes are varied and their objectives are often conflicting.
Conflict of interest between the varied stakeholders causes agency problems.
To resolve such agency problems monitoring and control mechanisms become imperative.
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AGENCY COSTS AND CORPORATE GOVERNANCE
Such mechanisms entail costs that are termed as agency costs.
Agency costs take the form of either incentives to management like bonuses, stock options or monitoring and control costs like audit fees, credit rating fees etc.
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AGENCY COSTS AND CORPORATE GOVERNANCE
Corporate governance is another mechanism to protect the interest of the shareholders.
Set of rules, processes, and customs that enable the effective management of firms in the best interest of shareholders are termed as corporate governance.
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FINANCIAL MANAGEMENT AND ACCOUNTING
Financial management is intricately related to financial and management accounting.
The accounting information provides inputs for financial decision making.
Financial decisions in turn get reflected in the accounting statements.
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FINANCIAL MANAGEMENT AND ACCOUNTING
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FINANCIAL OBJECTIVES AND ORGANIZATIONAL
STRATEGY
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